Module 1: Introduction to Cost Accounting

Introduction
Accounting involves collection, recording, classification and presentation of financial data. The
word ‘Accounting‘ can be classified into three categories: (A) Financial Accounting (B)
Management Accounting and (C) Cost Accounting.

Branches of
Accounting

Financial Management Cost

Accounting Accounting Accounting

Management Accounting:
Management Accounting is a new approach to accounting. The term Management Accounting is
composed of two words — Management and Accounting. It refers to Accounting for the
Management. Management Accounting is a modern tool to management. Management
Accounting provides the techniques for interpretation of accounting data. Here, accounting
should serve the needs of management. Management is concerned with decision-making. So, the
role of management accounting is to facilitate the process of decision-making by the
management. Managers in all types of organizations need information about business activities
to plan, accurately, for the future and make decisions for achieving the goals of the enterprise.
Uncertainty is the characteristic of the decision-making process. Uncertainty cannot be
eliminated, altogether, but can be reduced. The function of Management Accounting is to reduce
the uncertainty and help the management in the decision making process. Management
accounting is that field of accounting, which deals with providing information including
financial accounting information to managers for their use in planning, decision-making,
performance evaluation, control, management of costs and cost determination for financial
reporting. Managerial accounting contains reports prepared to fulfil the needs of managements.
Different authorities have provided different definitions for the term ‗Management Accounting.
Some of them are as under: ―Management Accounting is concerned with accounting
information, which is useful to the management‖. —Robert N. Anthony ―Management
Accounting is concerned with the efficient management of a business through the presentation to
management of such information that will facilitate efficient planning and control‖. —Brown and
Howard ―Any form of Accounting which enables a business to be conducted more efficiently
can be regarded as Management Accounting‖ —The Institute of Chartered Accountants of
England and Wales.
Cost accounting and management accounting are both internal to an organisation. Both have,
more or less, the same objective of assisting management in it planning, decision making etc. It
is not worthwhile to distinguish the two inter-related disciplines as two branches of accounting.
Consider what experts opine in this regard.
Dobson : Management accounting is so broad and comprehensive that it includes both financial
and cost accounting.
C.T. Horngren : Cost accounting is management accounting plus a small part of financial
accounting.
It is because of the overlapping nature of the two in many areas, that everyone talks of cost and
management accounting as a single discipline. However, some distinctions can be drawn thus :

Basis Cost accounting Management accounting

Coverage It deals with ascertainment, allocation, It is concerned with the impact and effect
distribution and accounting aspects of aspects of costs.
costs
Position in Cost accountant is generally placed at a Management accountant assumes a superior
the lower level of hierarchy than a level in the management hierarchy.
hierarchy management accountant.
Approach Narrow, as the focus is, primarily on cost Wider, as one may have to use certain
data economic and statistical data along with
costing data to assist managerial decision
making
Emphasis It lays emphasis on cost ascertainment It is used as a decision making technique.
and cost control.
Scope The scope of cost accounting is limited It Makes use of other techniques like funds
to important techniques like variable flow, ratio analysis cash flow etc. in addition
costing,. break-even analysis and to variable costing, break-even analysis and
standard costing. standard costing. This includes financial
accounting, tax planning and tax accounting.
Focus It focuses on short term planning. It focuses on sort range and long range
Sophisticated tools not employed for planning and uses Sopmsticated technique in
forecasting purposes. the planning and control process.
Orientation Orientation It deals with data supplied by Futuristic in orientation, is more predictive in
financial accounting, orientation is not nature than cost accounting.
futuristic.
Evolution The evolution of cost accounting is It draws heavily on cost data and other
mainly due to the limitations of financial information derived from cost accounting. It is
accounting. merely an extension of the managerial aspects
of cost accounting.
Purpose Its main purpose is to report current and Its main objective is to provide all accounting
prospective costs of product, service, information relevant for use in formulation of
department, job or process policies; planning, controlling decision
making etc. to ensure maximum profit

Financial Accounting:
Financial Accounting has come into existence with the development of large-scale business in
the form of joint-stock companies. As public money is involved in share capital, Companies Act
has provided a legal framework to present the operating results and financial position of the
company. Financial Accounting is concerned with the preparation of Profit and Loss Account
and Balance Sheet to disclose information to the shareholders. Financial accounting is oriented
towards the preparation of financial statements, which summarises the results of operations for
select periods of time and show the financial position of the business on a particular date.
Financial Accounting is concerned with providing information to the external users. Preparation
of financial statements is a statutory obligation. Financial Accounting is required to be prepared
in accordance with Generally Accepted Accounting Principles and Practices. In fact, the
corporate laws that govern the enterprises not only make it mandatory to prepare such accounts,
but also lay down the format and information to be provided in such accounts. In sharp contrast,
management accounting is entirely optional and there is no standard format for preparation of the
reports. Financial Accounts relate to the business as a whole, while management accounts
focuses on parts or segments of the business.
Cost Accounting is a branch of accounting and has been developed due to limitations of financial
accounting. Financial accounting is primarily concerned with record keeping directed towards
the preparation of Profit and Loss Account and Balance Sheet. It provides information regarding
the profit and loss that the business enterprise is making and also its financial position on a
particular date. The financial accounting reports help the management to control in a general way
the various functions of the business but it fails to give detailed reports on the efficiency of
various divisions. The limitations of Financial Accounting which led to the development of cost
accounting are as follows.

Limitations of Financial Accounting

1. No clear idea of operating efficiency: Sometimes profits in an organization may be less or

more because of inflation or trade depression and not due to efficiency or inefficiency. But
financial accounting does not give a clear reason for profit or loss.
2. Weakness not spotted out by collective results: Financial Accounting shows the net result of
an organization. When the profit and loss account of an organization, shows less profit or a loss,
it does not give the reason for it or it does not show where the weakness lies.
3. Does not help in fixing the price: In Financial Accounting, we get the total cost of production
but it does not aid in -determining prices of the products, services, production order and lines of
products.
4. No classification of expenses and accounts: In Financial Accounting, we don’t get data
relating to costs incurred by departments, processes separately or per unit cost of product lines,
or cost incurred in various sales territories. Further expenses are not classified as direct or
indirect, controllable and uncontrollable overheads and the value added in each process is not
reported.
5. No data for comparison and decision making: It does not supply useful data to management
for comparison with previous period and for taking various financial decisions as introduction of
new products, replacement of labour by machines, price in normal or special circumstances,
producing a part in the factory or buying it from outside market, production of a product to be
continued or given up, priority accorded to different products, investment to be made in new
products or not etc.
6. No control on cost: Financial Accounting does not help to control materials, supplies, wages,
labour and overhead costs.
7. Does not provide standards to assess the performance: Financial Accounting does not help
in developing standards to assess the performance of various persons or departments. It also does
not help in checking that costs do not exceed a reasonable limit for a given quantum of work of
the requisite quality.
8. Provides only historical information: Financial Accounting records only the historical costs
incurred. It does not provide day-to-day cost information to the management for making
effective plans for the future.
9. No analysis of losses: It does not provide complete analysis of losses due to defective
material, idle time, idle plant and equipment etc.. In other words, no distinction is made between
avoidable and unavoidable wastage.
10. Inadequate information for reports: It does not provide adequate information for reports to
outside agencies such as banks, government, insurance companies and trade associations.
11. No answer for certain questions: Financial Accounting will not help to answer questions
like:-
(a) Should an attempt be made to sell more products or is the factory operating to capacity?
(b) if an order or contract is accepted, is the price obtainable sufficient to show a profit?
(c) if the manufacture or sale of product A were discontinued and efforts make to increase the
sale of B, what would be the effect on the net profit? (d) Why the profit of last year is of such a
small amount despite the fact that output was increased substantially? Etc.

Basis Financial Accounting Cost accounting

(i) Objective It provides information about the It provides information of
financial performance and financial ascertainment of cost to control cost
position of the business. and for decision making about the cost.
(ii) Nature It classifies records, presents and It classifies, records, presents, and
interprets transactions in terms of interprets in a significant manner the
money. material, labour and
Overheads cost.
(iii) Recording It records Historical data. It also records and presents the
of data estimated/budgeted data. It makes use
of both the historical costs and pre-
determined costs..
(iv) Users of The users of financial accounting The cost accounting information is used
information statements are shareholders, by internal management at different
creditors, financial analysts and levels.
government and its agencies, etc.
(v) Analysis It shows the profit/ loss of the It provides the details of cost and profit
of costs and organization. of each product, process, job, contracts,
profits etc.
(vi) Time Financial Statements are prepared for Its reports and statements are prepared
period a definite period, usually a year. as and when required.
(vii) A set format is used for presenting There are not any set formats for
Presentation financial information. presenting cost information.
of information
In spite of the above differences, both financial and cost accounting are in agreement regarding
actual cost data and product costing analysis. Values of stock and cost of goods produced and
sold are the main examples. For the preparation of the position statement, financial accountant
receives the necessary data from the cost accountant
Cost Accounting
As compared to the financial accounting, the focus of cost accounting is different. In the modern
days of cut throat competition, any business organization has to pay attention towards their cost
of production. Computation of cost on scientific basis and thereafter cost control and cost
reduction has become of paramount importance. Hence it has become essential to study the basic
principles and concepts of cost accounting. These are discussed in the subsequent paragraphs.

Cost: - Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a
given thing. It can also be described as the resources that have been sacrificed or must be
sacrificed to attain a particular objective. In other words, cost is the amount of resources used for
something which must be measured in terms of money. For example – Cost of preparing one cup
of tea is the amount incurred on the elements like material, labor and other expenses, similarly
cost of offering any services like banking is the amount of expenditure for offering that service.
Thus cost of production or cost of service can be calculated by ascertaining the resources used
for the production or services.

Costing:- Costing may be defined as ‘the technique and process of ascertaining costs’.
According to Wheldon, ‘Costing is classifying, recording, allocation and appropriation of
expenses for the determination of cost of products or services and for the presentation of suitably
arranged data for the purpose of control and guidance of management. It includes the
ascertainment of every order, job, contract, process, service units as may be appropriate. It deals
with the cost of production, selling and distribution. If we analyze the above definitions, it will
be understood that costing is basically the procedure of ascertaining the costs. As mentioned
above, for any business organization, ascertaining of costs is must and for this purpose a
scientific procedure should be followed. ‘Costing’ is precisely this procedure which helps them
to find out the costs of products or services.

Cost Accounting:- Cost Accounting primarily deals with collection, analysis of relevant of cost
data for interpretation and presentation for various problems of management. Cost accounting
accounts for the cost of products, service or an operation. It is defined as, ‘the establishment of
budgets, standard costs and actual costs of operations, processes, activities or products and the
analysis of variances, profitability or the social use of funds’.

Cost Accountancy:- Cost Accountancy is a broader term and is defined as, ‘the application of
costing and cost accounting principles, methods and techniques to the science and art and
practice of cost control and the ascertainment of profitability as well as presentation of
information for the purpose of managerial decision making.’ If we analyze the above definition,
the following points will emerge,
A. Cost accounting is basically application of the costing and cost accounting principles.
B. This application is with specific purpose and that is for the purpose of cost control,
ascertainment of profitability and also for presentation of information to facilitate decision
making.
C. Cost accounting is a combination of art and science, it is a science as it has well defined rules
and regulations, it is an art as application of any science requires art and it is a practice as it has
to be applied on continuous basis and is not a one time exercise.
Objectives of Cost Accounting
1. To analyze and classify all expenditure with reference to the cost of products and operations.
2. To arrive at the cost of production of every unit, job, operation, process, department or service
and to develop cost standard.
3. To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools. Analysis
of the causes of unsatisfactory results may indicate remedial measures.
4. To provide data for periodical profit and loss accounts and balance sheets at such intervals,
e.g. weekly, monthly or quarterly as may be desired by the management during the financial
year, not only for the whole business but also by departments or individual products. Also, to
explain in detail the exact reasons for profit or loss revealed in total in the profit and loss
accounts.
5. To reveal sources of economies in production having regard to methods, types of equipment,
design, output and layout. Daily, Weekly, Monthly or Quarterly information may be necessary to
ensure prompt constructive action.
6. To provide actual figures of costs for comparison with estimates and to serve as a guide for
future estimates or quotations and to assist the management in their price fixing policy.
7. To show, where Standard Costs are prepared, what the cost of production ought to be and with
which the actual costs which are eventually recorded may be compared.
8. To present comparative cost data for different periods and various volume of output and to
provide guidance in the development of business. This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and machinery in use as a basis
for examining its efficiency. A comparison with the performance of other types of machines may
suggest the necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that interim Profit and Loss
Account and Balance Sheet can be prepared without stock taking and checks on stores and
adjustments are made at frequent intervals. Also to provide the basis for production planning and
for avoiding unnecessary wastages or losses of materials and stores.

Last but not the least, to provide information to enable management to make short term decisions
of various types, such as quotation of price to special customers or during a slump, make or buy
decision, assigning priorities to various products, etc.

Importance of Cost Accounting

The limitations of financial accounting have made the management to realize the importance of
cost accounting. Whatever may be the type of business, it involves expenditure on labour,
materials and other items required for manufacturing and disposing of the product. The
management has to avoid the possibility of waste at each stage. It has to ensure that no machine
remains idle, efficient labour gets due incentive, by-products are properly utilized and costs are
properly ascertained. Besides the management, the creditors and employees are also benefited in
numerous ways by installation of a good costing system. Cost accounting increases the overall
productivity of an organization and serves as an important tool, in bringing prosperity to the
nation, thus, the importance of cost accounting can be discussed under the following headings:

a) Costing as an aid to management:- Cost accounting provides invaluable aid to management.

It provides detailed costing information to the management to enable them to maintain effective
control over stores and inventory, to increase efficiency of the organization and to check wastage
and losses. It facilitates delegation of responsibility for important tasks and rating of employees.
For all these the management should be capable of using the information provided by cost
accounts in a proper way. The various advantages derived by the management from a good
system of costing are as follows:
1. Cost accounting helps in periods of trade depression and trade competition. In periods of
trade depression, the organization cannot afford to have wastages which pass unchecked. The
management must know areas where economies may be sought, waste eliminated and efficiency
increased. The organization must wage a war not only for its survival but also continued growth.
The management should know the actual cost of their products before embarking on any scheme
of price reduction. Adequate system of costing facilitates this.
2. Cost accounting aids price fixation. Although the law of supply and demand determines the
price of the product, cost to the producer does play an important role. The producer can take
necessary guidance from his costing records in case he is in a position to fix or change the price
charged.
3. Cost accounting helps in making estimates. Adequate costing records provide a reliable
basis for making estimates and quoting tenders.
4. Cost accounting helps in channelizing production on right lines. Proper costing
information makes it possible for the management to distinguish between profitable and non-
profitable activities; profits can be maximized by concentrating on profitable operations and
eliminating non-profitable ones.
5. Cost accounting eliminates wastages. As cost accounting is concerned with detailed breakup
of costs, it is possible to check various forms of wastages or losses.
6. Cost accounting makes comparisons possible. Proper maintenance of costing records
provides various costing data for comparisons which in turn helps the management in
formulating future lines of action.
7. Cost accounting provides data for periodical Profit and Loss Account. Adequate costing
records provide the management with such data as may be necessary for preparation of Profit
and Loss Account and Balance Sheet at such intervals as may be desired by the management.
8. Cost accounting helps in determining and enhancing efficiency. Losses due to wastage of
materials, idle time of workers, poor supervision etc will be disclosed if the various operations
involved in the production are studied carefully. Efficiency can be measured, cost controlled and
various steps can be taken to increase the efficiency.
9. Cost accounting helps in inventory control. Cost accounting furnishes control which
management requires, in respect of stock of materials, work in progress and finished goods.

b) Costing as an aid to Creditors.

Investors, banks and other money lending institutions have a stake in the success of the business
concern are therefore benefitted immensely by the installation of an efficient system of costing.
They can base their judgment about the profitability and future prospects of the enterprise on the
costing records.

c) Costing as an aid to employees.

Employees have a vital interest in their employer’s enterprise in which they are employed. They
are benefited by a number of ways by the installation of an efficient system of costing. They are
benefited, through continuous employment and higher remuneration by way of incentives, bonus
plans, etc.

d) Costing as an aid to National Economy

An efficient system of costing brings prosperity to the business enterprise which in turn brings
prosperity to the business enterprise which in turn results in stepping up of the government
revenue. The overall economic development o f a country takes place as a consequence of
increase in efficiency of production. Control of costs, elimination of wastages and inefficiencies
led to the progress of the industry and, in consequence of the nation as a whole.

Certain Important Terms

Cost units- The Chartered Institute of Management Accountants, London, defines a unit of cost
as “a unit of quantity of product, service or time in relation to which costs may be ascertained or
expressed”. The forms of measurement used as cost units.
Cost centre – According to Chartered Institute of Management Accountants, London, cost
centre means “a location, person or item of equipment (or group of these) for which costs may be
ascertained and used for the purpose of cost control”. Cost centre is the smallest organizational
subunit for which separate cost collection is attempted. Thus cost centre refers to one of the
convenient unit into which the whole factory organization has been appropriately divided for
costing purposes. Each such unit consists of a department or a sub-department or item of
equipment or , machinery or a person or a group of persons. For example, although an assembly
department may be supervised by one foreman, it may contain several assembly lines. Some
times each assembly line is regarded as a separate cost centre with its own assistant foreman.
Profit centre – A profit centre is that segment of activity of a business which is responsible for
both revenue and expenses and discloses the profit of a particular segment of activity. Profit
centres are created to delegate responsibility to individuals and measure their performance.

Types and Methods of Costing

The basic principles of ascertaining costs are the same in every system of cost accounting.
However, the methods of analyzing and presenting the cost may vary from industry to industry.
The method to be used in collecting and presenting costs will depend upon the nature of
production. Basically there are two methods of costing, namely. Job costing and Process costing.
Job costing : Job costing is used where production is not repetitive and is done against orders.
The work is usually carried out within the factory. Each job is treated as a distinct unit, and
related costs are recorded separately. This type of costing is suitable to printers, machine tool
manufacturers, job foundries, furniture manufactures etc. The following methods are commonly
associated with job costing:
Batch costing : Where the cost of a group of product is ascertained, it is called ‘batch costing’.
In this case a batch of similar products is treated as a job. Costs are collected according to batch
order number and the total cost is divided by the numbers in a batch to find the unit cost of each
product. Batch costing is generally followed in general engineering factories which produce
components in convenient batches, biscuit factories, bakeries and pharmaceutical industries.
Contract costing: A contract is a big job and, hence, takes a longer time to complete. For each
individual contract, account is kept to record related expenses in a separate manner. It is usually
followed by concerns involved in construction work e.g. building roads, bridge and buildings etc.
Process Costing : Where an article has to undergo distinct processes before completion, it is
often desirable to find out the cost of that article at each process. A separate account for each
process is opened and all expenses are charged thereon. The cost of the product at each stage is,
thus, accounted for. The output of one process becomes the input to the next process. Hence, the
process cost per unit in different processes is added to find out the total cost per unit at the end.
Process costing is often found in such industries as chemicals, oil, textiles, plastics, paints,
rubber, food processors, flour, glass, cement, mining and meat packing. The following methods
are used in process costing :
Output/Unit Costing : This method is followed by concerns producing a single article or a few
articles which are indential and capable of being expressed in simple, quantitative units. This is
used in industries like mines, quarries, oil drilling, cement works, breweries, brick works etc. for
example, a tone of coal in collieries, one thousand bricks in brick works etc. The object here is to
find out the cost per unit of output and the cost of each item of such cost. A cost sheet is prepared
for a definite period. The cost per unit is calculated by dividing the total expenditure incurred
during a given period by the number of units produced during the same period.
Operating Costing : This method is applicable where services are rendered rather than goods
produced. The procedure is same as in the case of unit costing. The total expenses of the
operation are divided by the units and cost per unit of service is arrived at. This is followed in
transport undertakings, municipalities, hospitals, hotels etc.
Multiple Costing : Some products are so complex that no single system of costing is applicable.
Where a concern manufactures a number of components to be assembled into a complete article,
no one method would be suitable, as each component differs from the other in respect of
materials and the manufacturing process. In such cases, it is necessary to find out the cost of each
component and also the final product by combining the various methods discussed above. This
type of costing is followed to cost such products as radios, aeroplanes, cycles, watches, machine
tools, refrigerators, electric motors etc.
Operating Costing : In this method each operation at each stage of production or process is
separately identified and costed. The procedure is somewhat similar to the one followed in
process costing. Process costing involves the costing of large areas of activity whereas operation
costing is confined to every minute operation of each process. This method is followed in
industries with a continuous flow of work, producing articles of a standard nature, and which
pass through several distinct operation sin a sequence to completion. Since this method provides
for a minute analysis of cost, it ensures greater accuracy and better control of costs. The costs of
each operation per unit and cost per unit up to each stage of operation can be calculated quite
easily. This method is in force in industries where toys, leather and engineering goods are
manufactured.
Departmental Costing : When costs are ascertained department by department, such a method
is called ‘departmental costing’. Where the factory is divided into a number of departments, this
method is followed. The total cost of each department is ascertained and divided by the total
units produced in that department in order to obtain the cost per unit. This method is followed by
departmental stores, publishing houses etc.

Costing Systems
A. Historical Costing :- In this system, costs are ascertained only after they are incurred and that
is why it is called as historical costing system. For example, costs incurred in the month of April,
2007 may be ascertained and collected in the month of May. Such type of costing system is
extremely useful for conducting post-mortem examination of costs, i.e. analysis of the costs
incurred in the past. Historical costing system may not be useful from cost control point of view
but it certainly indicates a trend in the behavior of costs and is useful for estimation of costs in
future.
B. Absorption Costing: - In this type of costing system, costs are absorbed in the product units
irrespective of their nature. In other words, all fixed and variable costs are absorbed in the
products. It is based on the principle that costs should be charged or absorbed to whatever is
being costed, whether it is a cost unit, cost center.
C. Marginal Costing: - In Marginal Costing, only variable costs are charged to the products and
fixed costs are written off to the Costing Profit and Loss A/c. The principle followed in this case
is that since fixed costs are largely period costs, they should not enter into the production units.
Naturally, the fixed costs will not enter into the inventories and they will be valued at marginal
costs only.
D. Uniform Costing: - This is not a distinct method of costing but is the adoption of identical
costing principles and procedures by several units of the same industry or by several
undertakings by mutual agreement. Uniform costing facilitates valid comparisons between
organizations and helps in eliminating inefficiencies.
E. Differential Costing: Differential cost is the difference in total cost between alternatives-
evaluated to assist decision making. This technique draws the curtain between variable costs and
fixed costs. It takes into consideration fixed costs also (unlike marginal costing) for decision
making under certain circumstances. This technique considers all the revenue and cost
differences amongst the alternative courses, of action to assist management in arriving at an
appropriate decision.
F. Standard Costing: It refers to the ascertainment and use of standard costs and the
measurement and analysis of variances. Standard cost is a predetermined cost which is computed
in advance of production on the basis of a specification of all factors affecting costs. The
standards are fixed for each element of cost. To find out variances, the standard costs are
compared with actual costs. The variances are investigated later on and wherever necessary,
rectificational steps are initiated promptly. The technique helps in measuring the efficiency of
operations from time to time.

Cost classification
Costs can be classified or grouped according to their common characteristics. Proper
classification of costs is very important for identifying the costs with the cost centers or cost
units. The same costs are classified according to different ways of costing depending upon the
purpose to be achieved and requirements of a particular concern. The important ways of
classification are:
1. By Nature or Elements. According to the classification the costs are classified into three
categories i.e., Materials, Labour and Expenses. Materials can further be sub-classified as raw
materials components, spare parts, consumable stores, packing materials etc. This helps in
finding the total cost of production and the percentage of materials (labour or other expenses)
constituted in the total cost. It also helps in valuation of work-in-progress.
2. By Functions: This classification is on the basis of costs incurred in various functions of an
organization ie. Production, administration, selling and distribution. According to this
classification, costs are divided into Manufacturing and Production Costs and Commercial costs.
Manufacturing and Production Costs are costs involved in manufacture, construction and
fabrication of products.
Commercial Costs are (a) administration costs (b) selling and distribution costs.
3. By Degree of Traceability to the Product : According to this, costs are divided indirect costs
and indirect costs. Direct Costs are those costs which are incurred for a particular product and
can be identified with a particular cost centre or cost unit. Eg:- Materials, Labour. Indirect Costs
are those costs which are incurred for the benefit of a number of cost centre or cost units and
cannot be conveniently identified with a particular cost centre or cost unit. Eg:- Rent of Building,
electricity charges, salary of staff etc.
4. By change in activity or Volume: According to this costs are classified according to their
behavior in relation to changes in the level of activity or volume of production. They are fixed,
variable and semi-variable. Fixed Costs are those costs which remain fixed in total amount with
increase or decrease in the volume of the output or productive activity for a given period of time.
Fixed Costs per unit decreases as production increases and vice versa. Eg:- rent, insurance of
factory building, factory manager’s salary etc. Variable Costs are those costs which vary in
direct proportion to the volume of output. These costs fluctuate in total but remain constant per
unit as production activity changes. Eg:- direct material costs, direct labour costs, power, repairs
etc. Semi-variable Costs are those which are partly fixed and partly variable. For example;
Depreciation, for two shifts working the total depreciation may be only 50% more than that for
single shift working. They may change with comparatively small changes in output but not in the
same proportion.
5. Association with the Product: Cost can be classified as product costs and period costs.
Product costs are those which are traceable to the product and included in inventory cost, thus
product cost is full factory cost. Period costs are incurred on the basis of time such as rent,
salaries etc. thus it includes all selling and administration costs. These costs are incurred for a
period and are treated as expenses.
6. By Controllability: The CIMA defines controllable cost as “a cost which can be influenced
by the action of a specified member of an undertaking” and a non-controllable cost as “a cost
which cannot be influenced by the action of a specified member of an undertaking”.
7. By Normality: There are normal costs and abnormal costs. Normal costs are the costs which
are normally incurred at a given level of output under normal conditions. Abnormal costs are
costs incurred under abnormal conditions which are not normally incurred in the normal course
of production. Eg:- damaged goods due to machine break down, extra expenses due to disruption
of electricity, inefficiency of workers etc.
8. By Relationship with Accounting Period: There are capital and revenue expenses depending
on the length of the period for which it is incurred. The cost which is incurred in purchasing an
asset either to earn income or increasing the earning capacity of the business is called capital
cost, for example, the cost of a machine in a factory. Such cost is incurred at one point of time
but the benefits accruing from it are spread over a number of accounting years. The cost which is
incurred for maintaining an asset or running a business is revenue expenditure. Eg:- cost of
materials, salary and wages paid, depreciation, repairs and maintenance, selling and distribution.
9. By Time: Costs can be classified as 1) Historical cost and 2) Predetermined Costs. The costs
which are ascertained and recorded after it has been incurred is called historical costs. They are
based on recorded facts hence they can be verified and are always supported by evidences.
Predetermined costs are also known as estimated costs as they are computed in advance of
production taking into consideration the previous periods’ costs and the factors affecting such
costs. Predetermined costs when calculated scientifically become standard costs. Standard costs
are used to prepare budgets and then the actual cost incurred is later-on compared with such
predetermined cost and the variance is studied for future correction.

Elements of cost: The management of an organization needs necessary data to analyze and
classify costs for proper control and for taking decisions for future course of action. Hence the
total cost is analyzed by elements of costs ie by the nature of expenses. The elements of costs are
three and they are materials, labour and other expenses. These can be further analyzed as
follows.

These terms can be explained as follows

1. Direct Materials are those materials which can be identified in the product and can be
conveniently measured and directly charged to the product. For example, bricks in houses, wood
in furniture etc. Hence all raw materials, materials purchased specifically for a job or process like
glue for book making, parts or components purchased or produced like batteries for radios and
tyres for cycles, and primary packing materials are direct materials.
2. Indirect Materials are those materials which cannot be classified as direct materials.
Examples are consumables like cotton waste, lubricants, brooms, rags, cleaning materials,
materials for repairs and maintenance of fixed assets, high speed diesel used in power generators
etc.
3. Direct Labour is all labour expended in altering the construction, composition, confirmation
or condition of the product. Thus direct wages means the wages of labour which can be
conveniently identified or attributed wholly to a particular job, product or process or expended in
converting raw materials into finished goods. Thus payment made to groups of labourers
engaged in actual production, or carrying out of an operation or process, or supervision,
maintenance, tools setting, transportation of materials, inspection, analysis etc is direct labour.
4. Direct Expenses are expenses directly identified to a particular cost centre. Hence expenses
incurred for a particular product, job, department etc are direct expenses. Example royalty,
excise duty, hire charges of a specific plant and equipment, cost of any experimental work
carried out especially for a particular job, travelling expenses incurred in connection with a
particular contract or job etc.
5. Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour
and such other expenses including services as cannot conveniently be charged direct ot specific
cost units. Overheads may be sub-divided into (i) Manufacturing Overheads; (ii) Administration
Overheads; (iii) Selling Overheads; (iv) Distribution Overheads; (v) Research and Development
Overheads.

1. Prime cost = Direct Materials + Direct Labour+ Direct Expenses

(Note: Material consumed = opening stock + purchases
+ carriage inwards – closing stock)
2. Gross Works or Factory Cost = Prime Cost + Works or Factory Overheads
(Note: Net factory cost = Gross factory cost + opening stock of WIP – closing stock of
WIP)
3. Total Cost of Production = Factory cost or Works Cost + Administration Overheads
(Note: Cost of goods available for sale = Total Cost of production + opening stock of
finished goods)
4. Cost of Goods sold = Total cost of production + opening stock of finished goods –
closing stock of finished goods.
5. Total Cost or Cost of Sales = Cost of Production + Selling and Distribution Overheads
6. Sales = Total cost + profit

Cost Sheet
Cost Sheet is a statement of cost showing the total cost of production and profi t or loss from a
particular product or service. A Cost Sheet shows the cost in a systematic manner and element
wise. A typical format of the Cost Sheet is given below.
Numerical
Case study:
Prepare a Cost Sheet for the year ended 31.3.86 from the following figures extracted from the
books of Best Engineering Co.
Opening Stock:
(i) Raw Material 40,350,
(ii) Work-in-Progress 15,000 and
(iii) Finished Stock 35,590.

Cost incurred during the period:

Materials purchased 2,50,000, Wages paid 2,00,000, Carriage inward 2,000, Consumable Stores
10,000, Wages of Storekeeper 7,000, Depreciation of Plant & Machinery 10,000, Materials
destroyed by Fire 5,000, Repairs & Renewals 5,010, Office Manager’s Salary 10,000, Salary to
Office Staff 20,500, Printing & Stationary 10,000, Power 10,500, Lighting for Office Building
2,000, Carriage outward 3,000, Freight 5,000, Entertainment 2,500, Warehousing charges 1,500,
Legal charges 2,000, Expenses for participating in Industrial exhibition-6,000.

Closing Stock:
(i) Raw material 35,000,
(ii) Work-in-Progress 14,500, and
(iii) Finished Stock 40,030. Profit 25% on cost.
Installation of a Costing System
As explained above, cost accounting system is a system that accumulates costs, assigns them to
cost objects and reports cost information. In addition to this, a proper cost accounting system
assists management in the planning and control of the business operations as well as in analyzing
product profitability. There are several other advantages of a well defined costing system in an
organization like generating information for decision making, supplying information to the
management for internal control, detailed analysis of costs like fixed costs, variable costs,
controllable costs, labor costs, material costs, overheads etc. However it is necessary that the cost
accounting system is properly installed in an organization. Costing system installed in an
organization should be simple to understand, easy to operate, highly reliable and suitable to the
organization. The following factors should be taken into consideration while designing a costing
system.
I. Size of the firm: - Size of the firm is an extremely important factor in designing a cost
accounting system. As the size of the firm and its business grows, the volume and complexity of
the cost data also grows. In such situation, the cost accounting system should be capable of
supplying such information.
II. Manufacturing Process: - Process of manufacturer changes from industry to industry. In
some industries, there may be a continuous process of production while in some batch or job
type of production may be in operation. A cost accounting system should be such that the
manufacturing process is taken into consideration and cost data is collected accordingly.
III. Nature and Number of Products: - If a single product is produced, all costs like material,
labor and indirect expenses can be directly allocated to that product. But if more than one
product is manufactured, the question of allocation and apportionment as well as absorption of
indirect expenses ( Overheads ) arises and hence the cost accounting system should be designed
accordingly as more complex data will be required.
IV. Management Control Needs: - The designing of a cost accounting system in a business
organization is guided by the management control requirements. The costing system should
supply data to persons at different levels in the organization to take suitable action in their
respective areas.

Role of Management Accountancy

The role of management accounting and financial accounting is quite different from each other
as they have different goals altogether. Management accounting measures, analyzes and reports
financial and non financial information that helps managers to take decisions to fulfill the goals
of an organization. Managers use management accounting information to choose, communicate
and implement strategy. They also use management accounting information to coordinate
product design, production and marketing decisions. Management accounting focuses on internal
reporting. The following points highlight the role played by Management Accounting in the
business organization.
I. Implementing Strategy: Managers implement strategies by translating them into actions.
Creating value for customers is an important part of planning and implementation of strategies.
Strategic planning and implementation will include decisions regarding the design of products,
services or processes, research and development, production, marketing, distribution and
customer services. Each of this area is important for satisfying customers and keeping them
satisfied. Management accounting will help to track the costs of each of the activity mentioned
above. The ultimate target is to reduce costs in each category and to improve efficiency. Cost
information also helps managers make cost benefit analysis. For example, managers can fi nd out
that is it cheaper to buy products from outside vendors or to do manufacturing in-house? Is it
worthwhile to invest more resources in design and manufacturing if it reduces costs in marketing
and customer service?
II. Supply Chain Analysis: Companies can also implement strategy, cut costs and create value
by enhancing their supply chain. The term ‘Supply Chain’ describes the flow of goods, services
and information from the initial sources of materials and services to the delivery of products to
customers regardless of whether those activities occur in the same organization or in other
organization. Customers expect improved performance from companies through the supply
chain. They expect that the companies should perform all these activities in an efficient manner
so as to reduce costs and also maintain quality of the products and the products be available
easily for them. This is no doubt a daunting task and the management accounting plays a vital
role in ensuring value for money for the customers. Tools like standard costing and target costing
can be used effectively for cost control and cost reduction and thus ensure reasonable prices for
customers. A system of budgets and budgetary control will ensure continuous planning and
monitoring various functions and thus provide for introspection. Continuous improvement in
these activities will help in creating value for customers.
III. Decision Making: One of the important functions of management is decision making.
Management Accounting helps in this crucial area by providing relevant information to the
management. Techniques like marginal costing helps to generate information, which will be
useful for taking decisions. Decisions include make or buy decisions, adding or dropping a
product line, working of additional shift, shut down or continue operations, capital expenditure
decisions and so on. Decisions based on information are expected to be more rational and
objective rather than subjective.
IV. Performance Measurement: Management accounting helps immensely for the
measurement of performance of the organization. The main aspect of performance measurement
is comparison between the targets and actual. There are several tools and techniques like budgets
and budgetary control, standard costing and marginal costing, which are used in measuring the
actual performance against the target performance. This will facilitate introspection and
corrective action can be taken for further improving the performance.